Home >> Money Matters >> Chopping vs. Pruning

Chopping vs. Pruning

Asset reduction programs

In many cases, the credit available to distributors has all but dried up. Where money is available, banking requirements are becoming more restrictive almost every day. The likelihood of things getting better any time soon is remote.

With enough patience and concerted effort, the cash challenge associated with disappearing lines of credit can be overcome by rethinking gross margin and expense levels—even during a recession. However, many distributors need cash now, not in six months. The conclusion is that inventory and accounts receivable reductions are in order.

Exhibit 1

The Impact of an Investment and Sales Reduction
For a Typical MHEDA Member

 
      5% Investment  
      and Sales  
Income Statement ($) Current    Reduction  
Net Sales $25,000,000   $23,750,000  
Cost of Goods Sold 17,500,000   16,625,000  
Gross Margin 7,500,000   7,125,000  
Variable Expenses 1,375,000   1,306,250  
Fixed Expenses 5,625,000   5,625,000  
Total Expenses 7,000,000   6,931,250  
Profit Before Taxes $500,000   $193,750  
Income Statement (%)        
Net Sales 100.0 % 100.0 %
Cost of Goods Sold 70.0   70.0  
Gross Margin 30.0   30.0  
Variable Expenses 5.5   5.5  
Fixed Expenses 22.5   23.7  
Total Expenses 28.0   29.2  
Profit Before Taxes 2.0   0.8  
Key Investment Items        
Accounts Receivable $2,900,000   $2,755,000  
Inventory $3,200,000   $3,040,000  
Total Cash Freed Up     $305,000  

 

The reality is that most of the actions typically taken to lower investment levels are cash-positive in the short run and dangerously profit-negative in the long run. Given the multiple effects of cash generation programs, MHEDA members need to take a step back and rethink their investment levels in some different ways.

This report will examine two very different approaches to reducing the investment levels in accounts receivable and inventory:

• Chopping: An immediate reduction in investment levels to generate cash as quickly as possible.

• Pruning: A more gradual approach to investment reductions, but one which does not create long-term profit problems.

Chopping
Time to state the obvious—chopping is something of a pejorative. In extreme circumstances, however, it may be the only alternative. The problem is that it often is applied even when other alternatives are available. Very serious thought and care needs to be employed when adopting this strategy.

To fully understand the impact of this approach, it is first necessary to review where the typical MHEDA firm stands. Exhibit 1 on page 84 provides a financial overview of this typical firm based upon the Distributor Performance Benchmarking Report (DPBR). The first column in the exhibit reflects results before the current economic challenges.

Most of the actions typically taken to lower investment levels are cash-positive in the short run and dangerously profit-negative in the long run.

This firm generates $25,000,000 in revenue, resulting in a pre-tax profit of $500,000, or 2.0 percent of sales. Generating this level of performance requires an investment of $2,900,000 in accounts receivable and $3,200,000 in inventory.

Like every firm in every industry, this typical firm has both fixed expenses and variable expenses. Fixed expenses are overhead expenses that tend to be difficult to shed as sales fall. In contrast, variable expenses rise and fall directly with sales. These have been estimated to be 5.5 percent of sales. According to the DPBR, these figures are reasonably close to most MHEDA members.

The last column reflects the impact of a five percent reduction in both accounts receivable and inventory. As can be seen at the bottom of the exhibit, with the five percent reduction in these categories, a total of $305,000 is converted into cash. It provides the firm with substantial breathing room from a cash-flow perspective.

The challenge is that even with reductions as small as five percent, there is the likelihood of a sales decline because of the reduction in investment levels. If accounts receivable collections are tightened sharply and credit limits are lowered, sales suffer almost automatically. On the inventory side, the firm essentially places limits on the amount of merchandise that can be ordered. The result here is that the firm runs out of stock on key items quickly. Again, sales will suffer.

If sales decline by five percent (simply one of many potential scenarios), then pre-tax profit falls by $306,250. Assuming a 30 percent tax rate, the after-tax profit decline is $214,375. It needs to be noted that the $305,000 conversion of inventory and accounts receivable to cash is a one-time event, while the decline in profit after taxes of $214,375 is an every-year problem. It could even be worse, as being out of stock eventually creates serious customer-satisfaction issues.

There are also some other potentially negative effects from chopping that cannot be adequately quantified. An inventory reduction will necessitate ordering in smaller quantities. This could cause the firm to lose some order-quantity discounts. Ordering in smaller quantities also means more frequent ordering which increases receiving and stocking costs.

The case for chopping is much stronger if sales have already declined. In this case the firm is responding to a deteriorating situation. Even here, though, caution is in order. Investment reductions, particularly with regard to inventory, almost always cause a further deterioration in sales volume. If, for example, sales decline by 10 percent and inventory is cut by the same 10 percent, sales will almost certainly fall ever further because of the inventory reduction.

Pruning
In pruning the inventory, firms need to “de-deadify” the inventory. This means to focus only on dead inventory in an intense effort to eliminate items that have not registered meaningful sales activity over the last year.

Clearly, such inventory generates no sales volume. Converting the inventory to cash would not reduce the firm’s service level in any way. It is as close to a pure cash opportunity as exists today.

The Nature of the Pruning Opportunity

The pruning opportunity is almost entirely concentrated among slower-selling items, the so-called D items. However, it is essential to distinguish between dead inventory and simply slow sellers. As long as the D items have some reasonable sales opportunity, they are where the firm’s gross margin dollars are concentrated. They should not be pruned.

Product Percent Percent  
Category of Sales of Inventory Comments
A 60 45 Highly price-sensitive
      Must always be in stock
      Promote pricing and in-stock performance
       
B 20 20 Somewhat price-sensitive
      Typical service level
      Basic items
       
C 15 15 Slower sellers
      Price for margin
      Maintain adequate in-stock position
       
D 5 20 Specialty/unique items
      Price for maximum profit
      Eliminate dead inventory
Total 100 100  

 

The challenge, of course, is that nobody wants to buy the dead inventory or it wouldn’t be dead in the first place. This has caused most firms to ignore the pruning opportunity. However, through a combination of deep discounting, active promotion and simply dumping some inventory for a tax credit, substantial improvement is possible.

If the firm could eliminate 10 percent of its inventory, that is a reduction of $320,000. Since such merchandise is unlikely to generate more than 50 percent of its cost in discounted sales, the potential cash conversion is around $160,000. It is not an inconsequential change given that it should not come at the expense of a sales decline.

When pruning inventory, firms need to “de-deadify” it—focus only on eliminating items that have not registered meaningful sales activity over the last year.

Another downside to pruning is the time frame involved. A concerted de-deadifying project will take anywhere from three to six months to complete. In order for the project to be successful, somebody must be responsible for the process during that time. The entire firm must support the effort.

Investment Levels
When lines of credit dry up, changes in investment levels are almost inevitable. If at all possible, such reductions should be driven through pruning rather than chopping. The long-term sales and profit challenge is eliminated with this approach.

However, for firms with serious issues regarding cash flow, there may be no alternative to chopping. When contemplating such a drastic strategy, though, it is essential to be fully informed of the consequences. Unless planned properly, serious profit reductions will follow.

Material Handling Equipment Distributors Association
Al Bates Meet the Author
Albert D. Bates, Ph.D., is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.

Leave a Reply

Your email address will not be published. Required fields are marked *

*